Kevin Drum

Merry Christmas!

| Thu Dec. 25, 2008 10:20 AM PST

MERRY CHRISTMAS!....Santa brought Inkblot and Domino an exciting collection of boxes, ribbons, and wrapping tissue! They're very excited. What did Santa bring you?

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Your Christmas Eve Miracle Story

| Wed Dec. 24, 2008 4:30 PM PST

YOUR CHRISTMAS EVE MIRACLE STORY....Our nation's news media is surprisingly devoid of feel-good Christmas stories for us today, so this will have to do: it's the tale of Bess, a little black cat who was, unbelievably, stranded underneath a window seat for nine weeks without food and water but then rescued and resuscitated.

This is not quite as good as the story of a cat who trekked 30 miles across town to find its owner. I'm not sure it's even as good as the story of my friend's cat, which had cancer and finally disappeared one night for good, only to show up two years later hale and hearty. What's more, poor Bess might have permanent neurological problems because of her trauma — though I'm not sure how you can tell in a cat anyway. But it's Christmas Eve, and she's back, and apparently she's happy and purring. Enjoy!

It's Lott-Tastic!

| Wed Dec. 24, 2008 11:47 AM PST

IT'S LOTT-TASTIC!....I just love me some righteous John Lott bashing, and Nate Silver delivers with the latest example of Lott's customary careful use of primary sources in an op-ed over at Fox News. It's true that his mistake is a small one in the grand scheme of things, but two items make this latest Lott affair especially awesome:

  1. The op-ed in question is co-authored by Ryan S. Lott. You may recall him as the "ry" in Mary Rosh. Awesome!

  2. In comments to Nate's post, Lott says both he and Fox have corrected the error. But it's a stealth correction: you'd never know the op-ed had been changed unless you clicked over to Lott's personal website where he mentions it. Awesome!

Good times. Brings back memories, this does.

Shadow Banking

| Wed Dec. 24, 2008 10:17 AM PST

SHADOW BANKING....Like Ezra Klein, Dean Baker, and me (and a cast of thousands) Paul Krugman is puzzled that so many economists failed to see the housing bubble in real time. But even those who did see it mostly didn't realize that the bursting of the bubble would lead to such an epic financial meltdown. Here's Krugman's explanation:

I think it's understandable, though not entirely forgivable, that economists didn't see the risks of a broad financial breakdown. We're accustomed to thinking of banks as big marble buildings with "member of the FDIC" signs in the window; besides, those are the institutions on whom the standard data series report. (Indeed, some economists still fixate on those data, which is why there are still economists denying that there's a credit crunch.) So neither the size nor the vulnerability of the "shadow" or parallel banking system were widely understood.

I don't know if this is right or not, but it's the first time I've really seen someone take a crack at addressing this question. So I thought I'd pass it along.

Question

| Wed Dec. 24, 2008 9:54 AM PST

QUESTION....What's the deal with fusion power these days? Is it still 30 years off, same as always?

Stupid Ratings Agency Tricks

| Tue Dec. 23, 2008 10:35 PM PST

STUPID RATINGS AGENCY TRICKS....In an obvious effort to avoid being tarred and feathered by an angry mob, Wall Street apparatchik Noah Millman engages in a lengthy self-criticism session tonight regarding "structured finance" — you know, mortgage securitization, credit default swaps, synthetic CDOs, and all the other financial weapons of mass destruction that have helped melt down the world lately. "I thought it would be of interest," he says, "to relate two stories from my long career in structured finance, one that may help explain why, if you asked me in 2004 or 2005, I would have staunchly defended structured finance technology as having real social benefit and why, by a couple of years later, it was clear to anyone looking honestly at the business that something had gone very wrong."

Yes! It would be! And all kidding aside, we've actually seen very little about this stuff written by the people who actually engineered it all. So it really is interesting.

Noah promises to tell us about the "promise and peril" of structured finance, and the "promise" part has to do with the way CDOs and CDS helped make it possible for banks to expand lending in the dismal wake of the Enron/Worldcom/dotcom bust in 2002. That's fine, but let's be honest: it's not what we're interested in, is it? We want to hear about how structured finance destroyed the planet. So let's skip right to the "peril" part.

And it's pretty good. Noah tells the story of the constant-proportion debt obligation, aka CPDO, a cute little invention of the end stage bubble industry. In a nutshell, here's how it worked: the issuer bought up a bunch of BBB securities, and every six months they sold off both the poor performers and the good performers, replacing them with more BBB securities. The idea was to keep the yield roughly the same over time, but since they lost money on the junk and made money on the good stuff, on average they came out even. Or even took a small loss, what with fees and all. So why bother?

Enter the rocket scientists. Even BBB securities are unlikely to default in the short term, which means that the CPDO is basically pretty safe since it sells stuff off every six months. And since it's safe, the issuer can borrow lots of money against it to invest in longer-term bonds. That's called leverage, my friends:

And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you've got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?

Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.

How did they justify that AAA rating? By looking at the historic cost of rolling credit derivatives on indices of investment-grade corporate issuers, which generally have a high-BBB rating. These had been around for about three years when the first CPDOs were rated, and the roll had never cost more than 3 basis points. Factoring in that cost, at a leverage of 15-to-1, and using historic 6-month default rates for the portfolio (since the index would be rolled every six months), the proposed trading strategy would never lose money. Hence a AAA rating.

Let me reiterate that, just to drive the point home. The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

....When I first heard about this product, I thought: whichever agencies rated this thing have lost their minds. When people asked me whether it made sense as an investment, I said: it's an outright fraud. You're practically guaranteed to lose money. I never bought or sold one of these things myself, and neither did anyone else in our group. But the existence of such a ridiculous product should have been a wake-up call about just how divorced from reality the agencies were. And if they were out to lunch on something as straightforwardly absurd as the CPDO, how out to lunch were they on other products, ones that were far more significant to the markets and the economy, where the absurdity of their assumptions was less-obvious.

The moral of this particular story is: back during the bubble the ratings agencies were idiots. And today, they might even be worse. Read the whole thing for more.

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Blago Update

| Tue Dec. 23, 2008 5:22 PM PST

BLAGO UPDATE....In a turn of events that should surprise no one, Barack Obama has investigated himself and discovered that his staff engaged in no wrongdoing in the Rod Blagojevich affair. According to investigation czar Greg Craig, the accounts he received from staff members "contain no indication of inappropriate discussions with the Governor or anyone from his office about a 'deal' or a quid pro quo arrangement in which he would receive a personal benefit in return for any specific appointment to fill the vacancy."

The reason Craig uncovered nothing wrong is almost certainly because nobody did anything wrong. Unfortunately, investigating oneself isn't likely to convince anyone who doesn't want to be convinced in the first place, which makes me think there really ought to be some way for prosecutor Patrick Fitzgerald to weigh in on this. I guess the rules don't allow it, and rules are rules, but still. In the Valerie Plame case, he at least released enough information in the charging documents to allow people to draw their own conclusions about who did what to whom, and perhaps, eventually, he'll do it this time too. It really doesn't seem right to just leave this hanging forever.

The Decline and Fall of the Newspaper

| Tue Dec. 23, 2008 12:51 PM PST

THE DECLINE AND FALL OF THE NEWSPAPER....I was going to write a post about the subject du jour, namely whether or not newspapers could have done a better job of reacting to the rise of the internet, but via Matt, I see that Tim Lee has pretty much done it for me. Nickel version: Yes, it would have been great if railroads had converted into airline companies, if IBM had taken PCs more seriously, and if newspapers had embraced the web, but that kind of thing is really, really hard to do. That's why it so rarely happens. Cannibalizing your own business is almost impossible for both institutional and economic reasons, and knowing that you're in the generic transportation business, not the train business (or the generic computing business or the generic information business) isn't nearly as profound an insight as some people think. Anyone who thinks differently needs to run an actual business first and then report back on how they did converting its core business into something brand new.

In any case, I have my doubts that there was ever a long-term business model that could have successfully transitioned newspapers onto the web. Sure, the print news media could have done more — though simply asserting that newspapers could and should have been way more awesome isn't very helpful — but the advertising revenue just isn't there to support the kind of reporting infrastructure that the print version of newspapering supported. This isn't for lack of trying, either. Everyone and his brother has tried to figure out a more lucrative web-based advertising model for news, and so far no one has succeeded. Bright ideas are still welcome, of course, but most likely even the best newspapers will eventually die off and be replaced by something entirely different. I'm not as convinced as some that the replacement will be as good, but I suppose old fogies have said that before too more than a few times. We'll just have to wait and see what our brave new bloggy/twittery/decentralized news biz manages to deliver.

Twitter Followup

| Tue Dec. 23, 2008 11:44 AM PST

TWITTER FOLLOWUP....Via James Joyner, Michael Arrington writes on his blog that he thinks Twitter has ruined uber-twitterer Robert Scoble's life:

I asked Robert how much time he actually spends on those services. He monitors them all day, he said, hitting refresh over and over on both (he doesn't use desktop clients to manage the services, and he says he doesn't like real-time streaming feature on Friendfeed). In addition to watching all day, he says he spends at least seven hours a day, seven days a week, actually reading and responding directly on those services.

That's 2,555 hours over the last year....It is an addiction.

What is the cost of this addiction? Well, I'll put his family life aside, that's his business. But his blog has clearly suffered. He now posts only a few times a week, sometimes sporadically writing multiple posts in a day but often skipping 3-4 days in between. A year ago, Robert wrote multiple posts, every day. I used to read his blog daily, now I visit once a week.

As an aside, I'll note how amusing it is that in the same way that people once complained that blogging crowded out "serious" long form work like books and magazine pieces, people are now starting to complain about Twitter crowding out "serious" blog posts. The worm, she does turn.

Anyway. I created a Twitter account a couple of days ago after I posted about it, since I figured that was the only way to get a better sense of what it was all about. So far, I've tweeted twice, so obviously I haven't exactly embraced the form. But in a way, I think Arrington's post captures one of the problems with Twitter: like Facebook, it doesn't really make too much sense unless you spend a lot of time with it. It doesn't have to be 2,555 hours a year, mind you, but both Facebook and Twitter strike me as things that are perhaps moderately useful if you use them occasionally, but potentially highly useful if you're logged into them constantly and use them as primary tools for keeping in touch with people. That's unlike the blogosphere, where most people pick three or four blogs to follow and read them once a day for 20 minutes or so, and it's one of the things that makes these services hard to "get" unless you're totally committed to them.

Of course, I could be full of hooey here. But that's my take so far.

Sand in the Gears

| Tue Dec. 23, 2008 11:11 AM PST

SAND IN THE GEARS....Dean Baker explains to Ezra Klein why so few economists predicted that the economy was headed for disaster: there's not much risk in agreeing with the conventional wisdom and being wrong, and there's not much reward in bucking the conventional wisdom and being right:

[W]hat would an economist expect to happen in a situation in which option one carries no risks and reasonable expected rewards and option two carries enormous risks and only moderately higher expected rewards? In short, the incentives in the economics profession, just as in finance, strongly encourage a lack of original thinking.

Actually, I think this is too simplistic. There are some exceptions, of course, but even the economists who saw the housing bubble for what it was mostly didn't predict that its bursting was going to cause a massive global credit crunch and the biggest slowdown since the Great Depression. In fact, to a large extent, we still don't quite know why the reaction to the housing bust has been so severe. So there's a genuine question here that's worth diving into in more detail.

Still, I think Baker is basically right, and it's worth keeping in mind how the incentives work in the finance industry. Suppose, for example, that everyone on Wall Street knows there's an investment strategy that will pay off big 19 years out of 20, but implode in that one remaining year. What's the right thing to do?

Obviously, the answer is: follow the flawed strategy. If you don't, and everyone else does, then within a couple of years you'll either get with the program or you'll be out of a job. Even in the absence of any kind of fraud or collusion or mass insanity, following a strategy that you know will be disastrous 5% of the time is simply too profitable to pass up.

Given that, what should be the role of the government in trying to prevent systemic meltdown? Regulations that target fraud are useful, but remember: even if everyone is purer than Caesar's wife, they'll still be forced to follow the flawed strategy. They can't afford not to, and unless they're smart enough to predict precisely when the 5% of disasters will take place (and few are), the collective result is some kind of periodic meltdown.

My own guess is that the answer is a set of regulations that slow things down. Something that throws just a little bit of sand in the gears of the global finance machine and prevents bubbles from growing quite as quickly as they otherwise might. Baker has proposed a small fee on financial transactions, for example, and that seems like the right kind of idea. I've long thought that very modest capital controls might also be a good idea, even for advanced economies. In the mortgage market, requiring even a small down payment plays the same role.

I think one misconception that's become awfully popular recently is that the current meltdown is a "black swan" event, a perfect storm that happens only once a century or so. But I think Paul Krugman has made a persuasive case (in both the original edition of The Return of Depression Economics and the new one) that the kind of bubble related disaster we're seeing now is simply a common feature of the modern, global, hyper-fast, hyper-unconstrained financial market. The only difference is that it's mostly affected only small countries in the past couple of decades, and now it's worked its way all the way up the food chain — and if we don't introduce a little bit of institutional deliberation and constraint into the system, this won't be the last time we see it. Given the limitations of human wetware, after all, there may be such a thing as a financial system that's too efficient.